ADBI Working Paper Series How Far Can Renminbi Internationalization Go? Yu Yongding No. 461 February 2014 Asian Development Bank Institute Yu Yongding is an academician and senior fellow at the Institute of World Economics and Politics, Chinese Academy of Social Sciences. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, the ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. ADBI encourages readers to post their comments on the main page for each working paper (given in the citation below). Some working papers may develop into other forms of publication. Suggested citation: Yu, Yongding. 2014. How Far Can Renminbi Internationalization Go? ADBI Working Paper 461. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/working- paper/2014/02/13/6136.how.far.can.renminbi.internationalization.go/ Please contact the author for information about this paper. Email: [email protected] Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2014 Asian Development Bank Institute ADBI Working Paper 461 Yu Abstract Since the formal launch of the renminbi trade settlement scheme in 2009, renminbi internationalization has made impressive inroads. The progress in renminbi trade settlement is especially impressive. However, Hong Kong, China’s offshore renminbi deposits failed to make significant progress as expected. The question of how far renminbi internationalization can go has become a common concern in the international financial community. This paper argues that while a contributing factor is the sheer size of the People’s Republic of China’s (PRC) trade and the convenience of using the renminbi for transaction settlements, exchange rate arbitrage and interest rate arbitrage matter also. Profits from arbitrages are the major driving forces of, but do not constitute a sustainable basis for, internationalization. A fundamental constraint for renminbi internationalization is the PRC’s capital controls. Before fully opening up its capital account and making the renminbi freely convertible, however, the PRC needs first to put its own house in order. Macroeconomic stability has to be achieved; the high ratio of financial leverage should be reduced; a rational and flexible interest rate structure must be created; and risk management capacity across industries should be established. Most importantly, the PRC must make the renminbi exchange rate flexible to reflect demand for and supply of foreign exchange in the market. The renminbi can and will become a major international currency eventually, but the road to internationalization is bound to be long and bumpy. JEL Classification: F31, F33 ADBI Working Paper 461 Yu Contents 1. Introduction ................................................................................................................ 3 2. Why and How Renminbi Internationalization Was Brought into the Policy Agenda .... 3 2.1 The Global Financial Crisis and Decision to Internationalize the Renminbi .... 3 3. How Renminbi Internationalization Has Been Pursued .............................................. 8 3.1 Road Map of Renminbi Internationalization .................................................... 8 3.2 Progress in Renminbi Internationalization ...................................................... 9 4. Renminbi Internationalization and Capital Account Liberalization ............................ 12 4.1 The Impact of Renminbi Internationalization on Capital Controls ................. 12 4.2 A New Stage of Capital Account Liberalization ............................................ 13 4.3 A Digression: Literature on Capital Account Liberalization ........................... 14 4.4 Prerequisites for Full Capital Account Liberalization ..................................... 16 5. The Prospects of Renminbi Internationalization ....................................................... 17 5.1 Different Routes to Renminbi Internationalization......................................... 17 5.2 The Prospect for Use of Renminbi as a Trade Settlement Currency ............ 18 5.3 The Prospect for Use of Renminbi as a Store of Value ................................ 19 5.4 Microeconomic Foundation for Renminbi Internationalization ...................... 21 6. Conclusion ............................................................................................................... 23 References ......................................................................................................................... 25 ADBI Working Paper 461 Yu 1. INTRODUCTION Over the past 4 years since the launch of the renminbi trade settlement scheme, renminbi internationalization has made impressive inroads. In Hong Kong, China, a renminbi offshore market has been established. International investors have benefited greatly from the renminbi business in Hong Kong, China. Coveting the gains, many economies are trying to follow suit. Renminbi offshore markets in Singapore, Taipei,China, and some European countries have begun to take shape. However, all is not well with renminbi internationalization. While the progress in renminbi trade settlement has more or less met market expectations, the use of the renminbi as a store of value has been lackluster in recent years, after the initial dramatic increase in the renminbi deposits held by nonresidents in Hong Kong, China. The question of how far renminbi internationalization can go has become a common concern in the international financial community. This paper attempts to identify the factors that are behind the evolution of renminbi internationalization and explain why a certain pattern in renminbi internationalization has emerged during the evolution. It argues that despite the impressive progress in renminbi internationalization, due to the changes in the domestic conditions in the People’s Republic of China (PRC) and the international environment, the speed of the internationalization is likely to slow in the near future. An important point the paper makes is that the PRC should maintain its gradualist approach toward capital account liberalization, even though the acceleration of capital account liberalization may give renminbi internationalization a great boost. The next section discusses the evolution of the motivations of the PRC monetary authority for promoting renminbi internationalization. The third section discusses the problems of and progress in renminbi internationalization made with the road map. The fourth section deals with the relationship between capital account liberalization and renminbi internationalization. The fifth section explores different prospects for renminbi internationalization according to different road maps. And the final section presents concluding remarks. 2. WHY AND HOW RENMINBI INTERNATIONALIZATION WAS BROUGHT INTO THE POLICY AGENDA 2.1 The Global Financial Crisis and Decision to Internationalize the Renminbi There is no other country except the PRC that has ever made the internationalization of their own national currency a national policy. Taking into consideration the fact that the Government of Japan initially launched the internationalization of the yen only reluctantly, yielding to the pressure from the United States (Takagi 2009), the PRC is the only country that has tried to internationalize its own currency on its own initiative. It begs the question as to why the PRC decided to push renminbi internationalization rather suddenly in the beginning of the second quarter of 2009. In the 1990s, the Government of the PRC made the integration of the country’s economy with the global economy a national policy. The integration has two important dimensions. The first is to participate fully in the international division of labor. The 3 ADBI Working Paper 461 Yu entry into the World Trade Organization (WTO) is a landmark for this dimension. The second is to participate fully in the global financial system. In 1994, the renminbi was devalued and a managed floating system was introduced. The PRC liberalized its current account by accepting Article VIII of the International Monetary Fund (IMF) in 1996 and set a road map for capital account liberalization at roughly the same time. It was expected that, in a few years’ time, the capital account would be fully liberalized and the renminbi fully convertible. However, the Asian financial crisis brought the process of capital account liberalization to an abrupt stop. During the crisis, the renminbi was repegged to the United States (US) dollar and capital control was tightened. The peg to the US dollar and capital control helped the PRC weather the storm of the Asian financial crisis. In 2001, the PRC came out of the crisis unscathed. In the 2000s, the maintenance of an annual growth rate higher than 8% became the single most important policy objective for the PRC government. This growth rate was regarded as indispensable for the creation